Pharma Industry Financial Analysis

Abstract

This document contains supporting data for the presentation on Financial Statement Analysis for Dr.Reddy’s and Cipla for financial years 2010-11 and 2011-12. The team used publicly available annual financial statements from the respective company’s websites.

Introduction

The team picked two Indian pharmaceutical companies based on their market capital and presence in the global market. Dr.Reddy’s incorporated in 1985 and had phenomenal success in making generic drugs. Dr.Reddy’s has presence in many global markets including USA, Europe, Russia and Japan. Cipla is one of the oldest pharmaceutical companies in India. Cipla pioneered bulk production of generic drugs and export to many countries. Cipla research and development had breakthrough in slashing prices of critical generic drugs for treating HIV and Cancer patients.

The team had picked 2010-11 and 2011-12 financial years for the analysis. Due to change in financial statement formats, we could not include 2009-10 statements.

Financial Statement Analysis

Dr. Reddy’s

Common Size Balance Sheet

Common Size Income Statement

Cash Flow Summary

CIPLA

Common Size Balance Sheet

Common Size Income Statement

Cash Flow Summary

Key Financial Ratios

Dr.Reddy’s

Cipla

 

Recommendation for Dr Reddy’s

No, from the market ratios, the PE ratio has fallen down, in 2011 the market was willing to pay 28 times the eps and in 2012 it came down to 25. It means the growth of the company from investors point of view is not very good.

No, from long term solvency ratios, it is running high risk with debt ratios above 0.5 and debt-equity ratios above 2, this company’s financial growth is more from the borrowers money, so its not completely safe to invest over the long run. As a shareholder, if these ratios are deteriorating, then their assets and equity are not sufficient to fund the total liabilities.

No, from short term solvency ratios, the current ratio is recorded < 1.5 (1.14 in 2011) and when this is correlated with the average collection period (88 in 2011 to 83 in 2011), it shows that if the trade receivables are delayed over the average collection period, then the company has to liquidate its current assets against trade payables. Dr. Reddy must reduce it short term borrowings and at the same time it should be able to reduce its average collection period.

NOTE: However from the annual report numbers, the company claims, it looks like it has good trust in the market which is earning good profits from the borrowed money and stock is upword.

What is the degree of risk inherent in the investment?

In 2011&2012, more than 50% (Debt Ratios) of company’s assets are financed through debt. D-E ratios are also high which tells us that the company is running high financial risk.

Should existing investment holdings be liquidated?

In 2011, the current ratio was very close to 1 (1.14), considering avg account receivables close to 3 months, it ran the CA to CL neck to neck. Any more delay in TRs would make the company to sell off its assets against TPs. In 2012 it is good.

 

Recommendation for CIPLA

Yes, from the market ratios, PE ratio is increased from 26 to 28 which shows the market is willing to pay even more over 2011.

Yes, from the long term solvency ratios, debt ratios are around 0.2 and debt-equity is around 1.2, which shows that company’s assets and equities would be enough to fund shareholders money in case of company bankrupt on the long run in the worst case, otherwise would return good returns.

Yes, from short term solvency ratios, current ratios are around 3, which is very good for short term investors.

What is the degree of risk inherent in the investment?

Financial risk is low as they are financed for assets from debts only for 20%. Their D-E ratios are quite low which reflects less risk.

Should existing investment holdings be liquidated?

Not at all, it is running very good CRs. In fact it is wasting some investments, instead it can do some more investments and generate more returns.

 

CONCLUSION

• Generally accepted accounting principles(GAAP) were adopted and practiced in both the firms Dr.Reddy’s and Cipla.

• Rupees depreciated by more than 14% as compared to US dollar and this has helped CIPLA and Dr.Reddy to achieve significant profit from exports.

• Dr. Reddy’s has EPS of 76.72 in 2012 whereas Cipla has EPS of only 14.25 and this is indicated in the net income as well where Reddy has increased its net revenues by 32% YoY whereas Cipla has managed to increase it by 12% YoY. However, market sentiment does not seem to appreciate this as P/E ratio for Dr. Reddy’s has come down from 26 to 22 and Cipla has come down by 25 to 22. Clearly the total liabilities is weighing them down.

• From the analysis we would not vote for both CIPLA and Dr Reddy’s. CIPLA would need further more analyzation based on their sudden shifts in reduction of liabilities and increase of assets. Dr Reddy’s is imposing financial risk on already existing business risk and hence we cannot predict the long term financial stability of the company, it depends on several external factors like economy of the country, industry competition, etc.

 

References

Fraser, Lyn M., Ormiston, Aileen (2011). Understanding Financial Statements. PHI Learning Pvt. Ltd.,

“Dr.Reddy’s Annual Report 2011-12”. http://www.drreddys.com/investors/pdf/annualreport2012.pdf

“Cipla Audited Consolidated Financial Results 31st March 2012”. http://www.cipla.com/CiplaSite/Media/PDF/Financial-Results/Audited-Consolidated-Financial-Results-31st-March-2012.pdf?ext=.pdf

 

Pharma – ANALYSIS REPORTS (attachments)

Pharma Finanical analysis-Group6

Pharma Finanical analysis-Group6 Presentation

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Ratio Analysis in Financial Accounting

Ratio Analysis in Financial Accounting

We do ratio analysis to evaluate company’s financial position and performance. These ratios are also used to evaluate trend, like compare current year numbers with previous years of the same company or different company in same industry or whole industry or entire economy.

Liquidity Ratios: These ratios tells us if a business have enough money to pay to the creditors. It is also called as short term solvency ratios as it shows us if a business can pay its current liabilities from its current assets. This is more relevant to short term creditors.

Leverage/Solvency Ratios: These ratio tells us the usage of debt money over long run, hence leveraging involves financial risk. It indicates the financial risk that the company is running. These are also called long term solvency ratios. This is of interest to the investors, owners, government etc

Profitability Ratios: To measure overall efficiency and performance. This tells us how much service a company is doing to its owners.

Note: Liquidity and Leverage ratios shows business’ financial position, whereas profitability ratio shows business’ financial performance.

Turnover Ratios: All turnover ratios indicate the efficiency of usage of assets, i.e, the higher the turnover ratio, the better the utilization of assets.

Valuation Ratios: these are market related

Lenders priority queue if a company is bankrupt

If a company is bankrupt, then the lenders to receive the money in the queue would be,

secured creditors, statutory dues (PF, retirement benefits, etc), employees, unsecured creditors, preference capital shares and last comes the equity shares.

So investing in equity shares is always associated with the business risk.

Consolidated Cash Flows

Consolidated Cash Flows

There are three types of cash flows that happen

  • from operations – this generates profit, this profit is arrived at after taking non-cash expenditure into the consideration such as deferred tax, provision, depreciation. So operations will generate PAT + deferred tax + depreciation
  • from investment activities – how much are we investing in long term non-current assets (like fixed assets, long term investments, etc)
  • from financial activities

MONEY COMING IN can be Liability or Income

  • Liability is money which comes in but has to be paid back
  • Income is money which comes in and we can hold it

MONEY GOING OUT has to be an Expense or an Asset

  • Expense is money which goes out and we cannot get it back
  • Asset is money which goes out and it holds some lasting value

OR
————————-Increase                      Decrease
Liabilities              CASH INFLOW                   CASH OUTFLOW
Assets                   CASH OUTFLOW               CASH INFLOW

Operating Cycle of any typical business

Every business has its own operating cycle through which business goes through.

A typical example is

CASH — RAW_MATERIAL — WORK_IN_PROGRESS — FINISHED_GOODS — ACCOUNTS_RECEIVABLE — CASH

Consolidated Balance Sheet

Consolidated Balance Sheet categorized into Assets & Liabilities

Assets
– Current Assets
– Non Current/Fixed assets
Liabilities
– Equity, i.e, owner’s money
– Debt, i.e, borrowers money

Assets: In B/S this is where the money goes out.
Current Assets: All the assets along the operating cycle are called current assets. CAs consists of cash OR mere cash items in the cycle.

  • Current Investments: These are the investments that can be readily converted into cash.
  • Inventory: Inventory/Stock is combination of ‘ RAW_MATERIAL — WORK_IN_PROGRESS — FINISHED_GOODS’ in the operating cycle.
  • Unbilled Revenue: This is specific to service based/IT companies. WORK_IN_PROGRESS is known as UR. In IT sector, it means the running projects which are not yet completed. All the salaries paid to the employees during this period is actually an expense but since these projects are going to generate money we pull it out from P/L account and put into B/S (here) as revenue.
    Note: This also happens to the R&D centers. If research goes for a long time and if the product is not yet finalized then all the salaries paid during this time as well as other expenses incurred are pulled out of P/L account (Expenses) and put into the B/S under assets(Unbilled Revenue). This is known as CAPITALIZATION. And this amount will be moved into P/L account during the next financial year provided the project is delivered. This is COGS which are not actually sold.
  • Trade Receivables: These are the account receivables. This is calculated at the current market rate as the goods are already sold and money is yet to be received. TRs are always billed at the Selling Price.
  • Cash and bank Balances
  • Short-term loans and advances: given from company to others
  • Other current assets

Non Current Assets:
All the assets which are used for the operating cycle, which by they themselves do not get converted into cash/Account Receivables,  but are the assets used to generate the revenue are called Non-Current Assets/Fixed Assets. These are of two types

  • Tangible Assets: something which can be felt
  • Intangible Assets: something like formulae through which we generate something

 

Liabilities: In B/S this is where the money comes in, in form of owner’s equity and debt.
Share Holder’s Money, also called EQUITY, is a combination of ‘share capital’ and ‘reserves & surplus’.
Share Capital: The actual initial investment made by the owners.

  • Authorized Capital: This is the capital raised by owners
  • Issued Capital: IPOs (above)
  • Subscribed Capital: (above)
  • Fully Paid Up: When the Board of directors (BODs) sit and allot the shares

Reserves and Surplus: This is the profits that they have made in the last year and the share premium that they have received. Reserves are of two types

  • Revenue Reserve: is what you earn and retain in the business
  • Capital Reserve: is the premium paid on each share, benefits contributed by government etc
  • Long term liabilities: Here company will borrow money against debentures. This is contributed from employees retirement benefits, gratuity, superannuation etc. This is actually expense which is booked in the long term and but booked as liabilities for the current financial year.
  • Short Term Liabilities: are trade credits/trade payables. Trade Payables are exactly opposite of Account Receivables.

Apart from equity, the remaining money under liabilities is the borrowers money.

Note: In India there are two types of shares

  • Equity Shares: these are issued, subscribed and fully paid up shares. These are non-redeemable.
  • Preferal Shares: are holders of those shares who have the preferential rights to get back the capital in case the company defaults.

All about financial accounting statements

Financial Accounting Statements are all about

  1. Balance Sheet (B/S)
  2. Profit/Loss Account(P/L)
  3. Cash Flow Statement

Accounting is all to do with Assets, Liabilities, Income and Expenses (A LIE )

Assets are anything of value that we have got today like bank balance, fixed deposits, shares, buildings, land etc.

Liabilities is the money that has been taken for acquiring the assets which has to be discharged over a period of time.

Once something is placed into B/S, it is considered as an asset, which can be realized. On the other hand if something is finding a place in P/L account then it is over and out.

Balance Sheet and Profit/Loss Account Stmt:

Balance Sheet shows the position of an individual/firm at given point of time with respect to assets and liabilities. End result of the B/S gives us the equity of the owner. And now this position which is derived from B/S alone is not enough to invest in the company, we need to understand what does an individual/firm do for its living/existence, so that we can measure its performance over a period of time in the recent past. And this performance is known as profit/loss account. End result of the P/L account is a performance report which shows us how much an individual has earned (Income), and what has individual spent (Expenses) and derive at the profit or loss.

Net Equity becomes the equity resulted from B/S sheet and the profit/loss resulted from P/L account.

How are balance sheet and profit-loss accounts related?

Always these two accounts are linked together such that at any given point of time they reflect individual’s position instantly, i.e, position as of the current date and his performance over a period of time.

Cash Flow Statements:

Information on investments, operations and financials is obtained from cash flow statements. Cash flow statement is basically difference between two balance sheet dates which decides whether money has gone out or come in. Every entry in B/S will be placed into one of the cash flow categories.

Journal, Ledger, Trial Balance and Financial Accounting

Journal, Ledger, Trial Balance and Financial Accounting

Journal is a book into which every transaction with a voucher gets recorded.

Ledger is another book which is opened from Journal book in which there is one dedicated page for every account.

Posting in the ledger means taking every transaction from the journal and putting it in appropriate account in the ledger.

Process of  tracing back to the right voucher from the ledger book is called as Audit Trial.

Trial Balance: Once the ledger posting is done, we prepare a trial balance which is summation of all the pages in the ledger book. From this TRIAL BALANCE we pull out Balance Sheet Statements and Profit&Loss Account, and Cash Flow is just an extension to B/S and P/L statements.

Government Expenditure and Fiscal Deficit

Government carries out following expenditures

  • consumption expenditure (pay salaries to govt officials, construct buildings, lands etc)
  • investment expenditure (infrastructure such as roads, dams etc)
  • transfer payments (like subsidies, which does not fetch anything in return to the govt)
Percentages 2004-05 2005-06 2006-07 2007-08a 2008-09
Consumption 55.50 54.46 51.86 50.28 52.49
Capital Formation 37.52 39.54 41.91 43.14 42.13
Transfers 6.97 6.00 6.23 6.59 5.39
  • From this analysis, around 60% of government expenditure is on consumption and transfers, and only 40% is investment on capital formation.
GDP(Y) = C + I + G + (Ex - Im)
  where
  C         = Consumer Spending
  I         = Investment made by industry
 (Ex - Im)  = Excess of Exports over Imports
  G         = Government Spending

Now lets assume we don’t depend on the external factors, hence (Net Imports = Net Exports = 0)

Y=C+I+G
Y-C-G=I

If we assume the total govt expenditure is equal to govt expenditure and consumption expenditure, then

Income-(Consumption Expenditure + Govt Consumption) =  I
Income-(Total Consumption) = Savings = I

In other words the national savings of an economy are diverted to investments.

What is fiscal deficit?
If a country spends more than its income then it has to borrow which is called as FISCAL DEFICIT.

Today in India we are running fiscal deficit, hence borrowing huge amounts of money and using it in form of subsidies and other consumption instead of investments. This is why fiscal deficit is bad for growth or investments. If this is prolonged then it leads to the collapse of our economy.

One of the reason for food inflation in INDIA

One of the reason for food inflation in INDIA

In INDIA, NREGS- National Rural Employment Guarantee Scheme, by government of India guaranteed the wages to every household which increased the wages. Increase in wages has led to the increase in purchasing power which inturn has led to increase the demand. Now increase in demand should always be supplemented with increase in supply, if supply doesn’t increases with the demand then prices will shoot up. This is what is happening in India and is the main cause of food inflation.

Note: Inflation is weighted index and food inflation is just one factor in it. Change in overall inflation might/might-not affect the food inflation. And major driving factor of India’s inflation today is food inflation.

Sometimes what seems to be morally right is economically wrong which can be observed in governments scheme NREGS to help below poverty line people (BPL).

Note: Wages and production are interlinked, the more the productivity the more will be the wages. In IT sector wages/salaries are high because of high productivity whereas in agriculture the wages are going down which means the productivity is going down.

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